Is Health Care Broken Because of Tax Breaks?

By Robert P. Murphy

March 10, 2017 — Reading Time: 4 minutes

It’s not surprising that progressives oppose the GOP health insurance plan as being heartless, and it’s not surprising that many conservatives and libertarians oppose the plan for keeping too much of ObamaCare intact. Yet what is odd is how many free-market economists (e.g. here and here) are very upset because the plan refrains from massive taxes on employer-provided health plans. This is actually a common complaint in free-market circles, but I think it is blown badly out of proportion.

As my co-author Doug McGuff and I relate in our book on the history of U.S. health care and insurance, there has been a long series of government interventions into American medicine. Regarding employer-provided insurance plans, one important episode was the wage and price controls during World War II. Employers were forbidden from offering higher salaries to attract employees, but they were allowed to offer premium payments for health insurance as part of a compensation package.

Even after the war ended, the nudge for employer-provided plans was embedded in the tax code. If your company pays you $100,000 in salary, out of which you buy your own health insurance, then you get taxed fully on the $100,000. However, if your company pays you $90,000 in salary and spends $10,000 in premiums for you and your family’s health insurance, then you only get taxed on the $90,000 and your company gets to deduct the full $100,000 as a business expense. For employees in high tax brackets, this is a significant issue and helps explain why so many Americans would want health insurance to be part of a standard compensation package.

However, if one were going to design a tax code from scratch (and let’s assume for the moment that we don’t have the option of saying “no taxes”), most free-market economists agree that you would not want the government picking certain sectors over others. Instead, you’d want the government to raise the target amount of revenue by levying a flat tax with the lowest possible rate on the widest possible base. By declaring certain activities income-tax exempt, that simply distorts incentives and leads to additional inefficiencies on top of the original problem of transferring resources to the government.

Yet even though I agree with this type of analysis insofar as it goes, many free-market economists (such as the two I linked in the first paragraph above) have gone farther, and are lamenting the fact that the GOP plan has abandoned the Affordable Care Act’s provision to slap a huge 40% tax on “Cadillac” employer health insurance plans. (For what it’s worth, Rand Paul is complaining that the GOP plan retains the Cadillac tax–so poor Paul Ryan can’t catch a break.)

According to the free-market economist critics, by keeping the tax deduction for employer-provided plans, the GOP would simply lock in the perverse structure of our current system, where individual consumers don’t make health care spending decisions. This is why (they claim) costs are so out of control.

But does this really make sense? The quickest way I can illustrate my doubt is to use an analogy. Suppose that the tax code allowed employers to make the car payments for their employees, without that being construed as taxable compensation to the employees. (In the case of “company cars” I think this is already the case, which just makes my analysis even more solid. But my understanding is that in general “fringe benefits” are supposed to be declared as taxable income at a fair market value.)

For example, a company could hire a new employee and give him $80,000 in salary and a new $20,000 car. The employee would just be taxed as if he were paid $80,000 with no other benefit. Thus, the employee would get his new car with pre-tax dollars through this arrangement, which would mean a lot of savings for employees in high brackets.

So suppose this reform goes through, and we check in on the U.S. economy in 20 years. What will we see? Because of the huge tax advantage, let’s suppose that all Americans with steady office jobs just about always buy their cars through their employer, rather than paying with after-tax dollars themselves.

This would certainly mean higher expenditures on cars in the United States. There would be a new inefficiency because of the change. For example, an employee might want his employer to spend $20,000 on a new car that the employee really only would spend $18,000 out of pocket on, because of the tax wedge.

Yet even so, do free-market economists think that Americans would consider the car market “broken”? Would people in between jobs find it impossible to buy an affordable car?

I don’t see why. So long as there were still competition in the industry, there’s no reason to suppose that people paying out of pocket would be hit with bigger markups than before. In fact, with economies of scale, it’s even possible that people paying out of pocket ended up with better options after the tax reform.

Furthermore, even though there would be more bureaucracy and headaches from employees having to send paperwork to their corporate office–the car dealership would be dealing with their employer, not with the individual consumer directly–I don’t think we would see absurdities such as a dealership charging $500 for an oil change. The major employers would still be spending real money–their money–on this perq of “car services” for their employees, and every dollar the company saved (without sacrificing employee satisfaction) would be an extra dollar for the shareholders. Just because a big company spends money, doesn’t mean it’s painless.

In summary, I think if the tax code let employers provide car services to employees with no tax bite, then Americans would end up driving around in much nicer cars. There would also be inefficiency in the sense that more than the optimal amount of resources would go into the car sector. However, there would still be a healthy market with competition and cost-conscious expenditures, such that car producers would be earning the greater expenditures. And people who paid out of pocket for used cars would still find good deals; there is no reason that the secondhand market would break down.

So no, contrary to many free-market economists, I don’t think the craziness of our current health care system is due to incentives in the tax code. If you wanted to wreck the private car market in America, it wouldn’t be enough to privilege auto expenditures in the tax code. Instead you would also need to do things like (a) pass strict licensing requirements on who could sell a car, (b) allow for huge lawsuits against the manufacturer in the event of a car crash, and (c) have a decade-long approval process, costing billions of dollars in testing, before a producer could introduce a new car model. If you had those types of supply-side restrictions and then added a big demand subsidy, then you might see the car market start to resemble U.S. health care and insurance.